As a homeowner, you’ve likely heard that making an extra mortgage payment will result in big interest savings. Let’s take a closer look.
Potential benefits of making additional principal payments:
1. Save on interest
Since your interest is calculated on your remaining loan balance, paying additional principal payments early in the loan may result in a significant reduction in the total amount of interest over the life of your loan. Talk with your lender to determine your projected savings based on the size of your loan, your interest rate and scheduled payment dates. You can find online mortgage calculators to get a rough estimate. As an example, if you make an extra payment each year on your $250,000, 30-year mortgage at a rate of 3.4%, you will save over $20,000 in interest over the life of the loan. (Put your own values into this calculator from bankrate.com to see what your savings will be.)
2. Shorten the length of your mortgage
Sending additional principal payments will shorten the life of your mortgage and build equity faster. In the example above, one extra payment per year would shorten the length of your mortgage by nearly four years, assuming you make all your payments on time.
Potential risks of making additional principal payments:
1. Your funds are locked up
The funds you use to make the extra payment become part of the equity in your home and are not readily available for other needs. Be sure to have emergency funds available before you consider making extra mortgage payments. You may wish to save for other big events, such as college, vacations or weddings.
2. You forego other uses of your funds
With today’s historically low interest rates, there may be better uses for your funds than retiring your possibly tax-deductible mortgage early. You may want to consider paying off high-rate credit cards first, or consider investment opportunities, such as maximizing your IRA contribution. If you come into additional funds, such as an inheritance, you may want to speak with your mortgage lender before making additional principal payments, as taking out a new loan with adjusted terms may be a better option than simply paying more principal.
How to Make Extra Principal Payments:
If you decide to make extra principal payments, one recommended approach is to set up a separate savings account and deposit the extra payment each month. That way the money will still be available if you need it during the year and you can make one lump sum additional principal payment at the end of the year.
To get the maximum benefit, it’s important to identify that the extra payment should go toward principal and not interest. Depending on your mortgage servicer, you may be able to indicate this online. If you send a check, note on the check that it is for additional principal. When you get your statement after any extra payment, you can make sure it was applied correctly. If you choose to pay more each month, you can request a monthly statement. Typically, the extra payment does not trigger any penalties.
Unless you have an adjustable-rate mortgage (ARM) that recasts annually, making extra principal payments will not lower your monthly payments or your interest rate. In today’s low-interest environment, you will likely want a fixed-rate mortgage unless you plan to move soon.
Talk with your mortgage lender about your goals and time frame. Together, you can customize a solution that is right for you.